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Microfoundational Programs Microfoundational Programs Kevin D. Hoover HOPE Center Working Paper No. 2010-01 May 16, 2010 Duke University Center for the History of Political Economy Microfoundational Programs* Kevin D. Hoover Department of Economics and Department of Philosophy Duke University Box 90097 Durham, NC 27708-0097 Tel. (919) 660-1876 E-mail [email protected] Revised, 16 May 2010 *Prepared for the First International Symposium on the History of Economic Thought: “The Integration of Micro and Macroeconomics from a Historical Perspective,” University of São Paulo, Brazil, 3-5 August 2009. I thank Pedro Garcia Duarte, Gilberto Tadeu Lima, Thomas Mayer, Raul Cristóvão dos Santos, and two anonymous referees for comments on an earlier draft. Abstract of Microfoundational Programs by Kevin D. Hoover Department of Economics and Department of Philosophy Duke University The substantial questions of macroeconomics itself are very old, going back to the origins of economics itself. But professional self-consciousness of the distinction between macroeconomics and microeconomics dates only to the 1930s. The distinction was drawn quite independently of Keynes, yet Keynes’s General Theory led to its widespread adoption. The question of the relationship of microeconomics to macroeconomics encapsulated in the question of whether macroeconomics requires microfoundations was not raised for the first time in the 1960s or ‘70s, as is sometimes thought, but goes back to the very foundations of macroeconomics. There are in fact at least three microfoundational programs: a Marshallian program with its roots directly in Keynes’s own theorizing in the General Theory ; a fixed-price general-equilibrium theory, which includes some work of Patinkin, Clower, and Barro and Grossman; and the more recent representative-agent microfoundations, starting with Lucas and the new classicals in the early 1970s. This paper will document the development of each of these microfoundational programs and their interrelationship, especially in relationship to the programs of general-equilibrium theory and econometrics, whose modern incarnations both date from exactly the same period in the 1930s. JEL Codes: B2, B22, E1 Keywords: microfoundations of macroeconomics, general equilibrium, aggregation, representative agent, fixed-price models, econometric models Hoover, “Microfoundational Programs” 16 July 2009 1. Three Programs At least since the early 1980s with the ascent of the new classical macroeconomics, only macroeconomic models with explicit microfoundations have been regarded as fully acceptable. 1 Typical graduate textbooks – and, increasingly, undergraduate textbooks – open with dynamic optimization problems that are meant to connect the ordinary microeconomics of the consumer and firm to the behavior of aggregate data and to classic macroeconomic concerns such as the business cycle, growth, inflation, and interest rates (see inter alia Romer 1996, Blanchard and Fischer 1989, Barro 1984). How did microfoundations become the sine qua non of sound macroeconomics? There are many ways to tell this story – and, indeed, it has been told before. Here I will tell it from the perspective of the currently dominant practice. This is an exercise in economy rather than in Whig history. The story features neither triumph nor inevitable progress; rather it seeks to know why current practice is the way it is; and, as a result, it omits or minimizes alternative paths, including heterodox programs, such as post-Keynesian macroeconomics, and heterodox criticisms, such as those lodged by the Austrian school, as well as mainly pointing to certain aspects that are already well discussed elsewhere. 2 Lucas’s well-known article “Understanding Business Cycles” (1977) exemplified a widely accepted understanding of the emergence of modern microfoundations. In Lucas’s telling, modern macroeconomics began with John Maynard Keynes’s General Theory of Employment, Interest, and Money (1936). Keynes, according to Lucas, rejects a dynamic analysis of business cycles in favor of a static account of output determination (pp. 215-216); he rejects equilibrium theory (p. 219); and individual optimization – at least in the labor market (p. 220). Keynes’s theoretical strategy gives a boost to the nascent program of aggregative econometric modeling: The decision on the part of the most prestigious theorist of his day freed a generation of economists from the discipline imposed by equilibrium theory, and . this freedom was rapidly and fruitfully exploited by macroeconometricians. [p. 220] 1 See Hoover (1988) for an account of the new classical macroeconomics and the role of microfoundations in it. 2 See Harcourt 1977; Horwitz 2000; Weintraub 1977, 1979; Janssen 1993; Hartley 1997. 1 Hoover, “Microfoundational Programs” 16 July 2009 Lucas is, of course, aware that many Keynesian economists did consider the microeconomic basis for various components of the Keynesian model – the consumption function, the money-demand function, the investment function, the Phillips curve, and, in Lucas’s own work with Rapping, the labor-supply function – but these exercises fell short of incorporating the discipline of the optimization problem into the general- equilibrium framework (Lucas 1981, pp. 2-3; Lucas 2004, pp. 20-21; Lucas and Rapping 1969, 1970). The microeconomics of the various functions mainly served to suggest a list of regressors to “explain” their target variables. The regressions themselves were, in effect, merely rules of thumb – decisions rules for particular stable environments. Lucas (1977, pp. 220-221) did not deny that macroeconometric models constructed in this manner could well mimic the behavior of the actual economy, but appealing to the main theme of his famous article “Econometric Policy Evaluation: A Critique” (1976), he argued that the regressions would not isolate the invariants in the economy and that conditional forecasting (policy analysis) requires such invariants. Lucas (1980a, p. 286; 1987, p. 108) was willing to excuse the theoretical choices of Keynesian economists as the product of the exigencies of the Great Depression and the absence of appropriate tools. But economists after the development of the Arrow-Debreu contingent-claims framework can no longer be excused. New classical microfoundations begins with the optimization problems of individual agents. These are incorporated into a dynamic general-equilibrium model based in the contingent-claims framework. Dynamics in an uncertain world requires the formation of expectations. Rather than taking expectations to be exogenously given or based on arbitrary rules of thumb, the rational-expectations hypothesis assumes that self-interested agents will somehow find expectations that are consistent with a true model of the economic process. They may make expectational errors, but they will not make systematic errors. The rational-expectations hypothesis, because it incorporates – implicitly, at least – the whole model of the economy imposes consistency restrictions across the various equations. No part of the system is independent from the other parts. In Lucas’s account, modern microfoundations begins with the new classical revolution of the 1970s, the opening shot of which was the introduction of rational expectations into otherwise standard macromodels (e.g., Lucas 1972b; Sargent and Wallace 1975, 1976). While many economists find the perfectly competitive 2 Hoover, “Microfoundational Programs” 16 July 2009 general-equilibrium model too perfect and seek to capture some features with a Keynesian flavor by introducing realistic barriers to smoothly functioning markets, even these new Keynesians accept the main lines of Lucas’s story and support a nearly identical view of the nature and necessity of microfoundations (see, for example, Blanchard 2000). Call this common view the mainstream narrative. 3 There is – as there usually is in Whig histories – some truth to this story. But in telling a story of linear progress, the mainstream narrative misses a more complicated and more interesting story and misrepresents key elements. The microfoundations of macroeconomics was a problem long before the new classical revolution and long before the term “microfoundations” was current. Indeed, Keynes himself had a distinct approach to microfoundations. As I reconstruct the development of microfoundations, it comprises a prehistory and three distinct microfoundational programs. One program, which I associate with Lawrence Klein was mainly concerned with accessible data. The data was aggregate, and Klein wanted to know that its behavior was compatible with the economic behavior of individuals. Call this the aggregation program . A second program was theoretical. Taking macroeconomics to describe (theoretically or econometrically) robust features of the economy, it asked whether a fully disaggregated, general-equilibrium model could generate those features as a characteristic of the normal operation of the system. Call this the general-equilibrium program . The aggregation and general-equilibrium programs seek non-eliminative microfoundations. If they were perfectly successful, we would nonetheless continue to use macroeconomics. In contrast, Lucas advocates eliminative microfoundations: If these developments succeed, the term “macroeconomics” will simply disappear from use, and the modifer “micro” will become superfluous. We will simply speak, as did Smith, Ricardo, Marshall, and Walras, of economic theory. [Lucas 1987, pp. 107-108] 4 For reasons that will become clearer
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